A few days ago, I was having dinner with one of my friends, and the topic of the sub prime mortgage crisis inadvertently popped up. Dealing mainly in the science industry, she was what a financially sound person would label as a “layman” or in this case “laywoman”.

It was when she told me a wayward theory that doesn’t really quite depict the actual crisis, which made me realise that many actually have not that big of a clue what the crisis was really about. Much less how it started. Albeit constant blasting of the crisis headlines from media outputs like the newspapers or news broadcasts, not many actually really understood what it was all about.

Maybe it was the complexity of the explanation itself or that the fact “crisis” was much of a better leverage to manipulate with and all people had to know was that “crisis” equals to “bad”, period. I believe the following explanation will give a clearer picture of what really started it thereby making it easier for the “laymen” out there to relate.

Charlie Loans
Let’s say Charlie wants to buy a house and he doesn’t have enough money to pay the sum in full, so he goes to a bank and asks for a loan. This is normally called a mortgage loan. Fueled by low interest rates, which encourage lending, the loan to Charlie is easily given out when certain details like “debt repayable ability” is highly under estimated. You see, under the standard procedures, banks will normally go through a stringent checklist to assess the loaner’s ability to pay off the debt loaned to him or her before approving any loans. Because of their “unfortunate” judgement to mete out loans at that time, many of such “Charlie” loans were approved.

Now let’s start painting the real negative scenario. Charlie can’t repay his mortgage debt. That’s not all, majority of the “Charlie Loans” meted out to people can’t be received. When you can’t pay back what you loaned from the bank, they are obligated to take back whatever that is owned by you. This will come in the crude form of the initial purchase – the house. The banks would then resell this property in the form of foreclosure sale, and most of them are usually sold at a percentage loss compared to the initial market price. When the banks multiply this effect, the losses amounting will be nasty.

A financial innovation, which made matters worse, was that of the Mortgage-Backed Securities (MBS). MBS derives their value from mortgage payments and housing prices, thus when the source takes a hit, MBS tumble as well.
The only problem was that banks and other foreign investments actually poured substantial sums in the MBS. The direct hit caused the true value of losses to plummet unstoppably and banks started panicking when their capital is depleting to the point where they might have to activate their reserves, which will then be way below its statutory minimum.

Blinded Judgement
Imagine the repercussions of the plummet to the point where people started questioning the losses involved and how badly it could affect the economy. The questionings and losses incurred affected financial institutions, hedge fund houses, businesses, investors and normal people walking on the streets. The financial hurricane with the force like that of Katrina soon hit global investors’ sentiments when people started having a sudden realisation that the losses were akin to money disappearing in thin air. This was further re-enacted when the government stepped in and had to buy up majority of the banks and financial institutions on the brink of bankruptcy.

In short, the entire spiral of negativity was started more or less by “non-stringent policies” and “blinded foresight” of banks and over leveraged loan policies encouraged by the government. Of course, this brief explanation was just the main gist of what started it and doesn’t curtail in full to repercussions and whatnot that happened after that which was constantly over broadcasted by the media.

Most importantly, it’s pretty clear now that the sub prime mortgage crisis is not just about the word “Crisis”.